I’m not generally one who dwells on market valuations, but when particular investors begin talking about a substantially overvalued equity market my ears perk up. In his latest weekly missive John Hussman describes why he believes the market is grossly overvalued. I have been a long-time critic of the way Wall Street analysts value equities, but Mr. Hussman explains the flaws in this methodology far better than I can:
“On a valuation basis, the S&P 500 remains about 40% above historical norms on the basis of normalized earnings. The disparity between our valuation assessment and the putative undervaluation being touted by Wall Street analysts is so great that a few remarks are in order. First, virtually every assessment that “stocks are cheap” here is based on the ratio of the S&P 500 to year-ahead operating earnings estimates, and often comes with a comparison of the resulting “earnings yield” with the depressed 10-year Treasury yield. What’s fascinating about this is that this is the same basis on which analysts deemed stocks to be about 40% undervalued just prior to the 2007 top, following which the market plunged by more than half. There’s a great deal of analysis regarding forward operating earnings that I published in 2007, but probably the most comprehensive piece was Long Term Evidence on the Fed Model and Forward Operating P/E Ratios from August 20, 2007.
To properly understand the price-to-forward operating earnings ratio, you have to recognise that operating earnings exclude a whole host of charges – what some observers correctly call “recurring non-recurring” charges. These include large and often quite regular losses that the companies deem, often on the thinnest basis, to be detached from their core business – even if the losses are directly related to their core business. Items like enormous asset writeoffs come to mind. Moreover, the “forward” means that these are year-ahead analyst estimates, which are typically substantially higher than trailing 12-month reported earnings.
Think of it this way. Suppose your poodle is 40% overweight. Someone sells you a scale where every pound shown on the dial represents 1.4 pounds of actual weight. Guess what? Your poodle will step on that scale, and the dial will pleasantly report that your dog is at its ideal weight. That may be comforting if you don’t like to face reality, but the truth is, you’ve still got one sick puppy.
When you hear analysts say that the historical average P/E ratio is about 15, you have to recognise that this is the normal P/E based on trailing 12-month earnings after subtracting all writeoffs and other charges. Forward operating earnings are invariably much higher, and it turns out that the comparable historical norm, as I discuss in that 2007 piece, is only about 12. If you exclude the late 1990′s bubble valuations, you get a historical norm closer to 11.5. The 1982 and 1974 market lows occurred at about 6 times estimated forward operating earnings.”
Robert Shiller’s 10 year trailing PE appears to mesh well with Mr. Hussman’s theme of a severely overvalued equity market (see below). All of this makes one wonder if this bear market will end in similar fashion to the previous great secular bear markets – with dirt cheap valuations?
Source: Hussman Funds